11-1 ACCT 652 Accounting Week 8 Liabilities and Present value Some slides Times Mirror Higher Education Division, Inc. Used by permission 2016, Michael D. Kinsman, Ph.D. 1 1 Payroll accounting I am sure you enjoyed the problem you had to do on payroll accounting for tonight. I, too, hate payroll. That s why my advice to clients, and to you, is Hire a payroll service to do payroll. It s not expensive, payroll takes time, and if you only do a few checks you often make mistakes. 2 Payroll accounting You will not be tested on the details of payroll. It is important for you to know, however, that taxes FICA, Medicare, FUTA, SUI, SDI, federal withholding, state withholding, and a myriad of anything else they want to tax are calculated and charged in doing payroll. 3
11-2 Defining and Classifying Liabilities ➊ Obligated in the present ➋ To pay out assets or deliver services in the future ➌ Because of a past event. Past event Past event Present obligation Future sacrifice Past Present Future 4 Current Liabilities Expected to be paid by using existing current assets or creating other current liabilities. Due within one year or the company s operating cycle, whichever is longer. Examples include accounts payable, shortterm notes payable, wages payable, warranty liabilities, lease liabilities, payroll taxes payable and unearned revenues. 5 Long-Term Liabilities Obligations that are not expected to be paid within one year or a longer operating cycle are called Long term liabilities. Examples include long-term notes payable, warranty liabilities, lease liabilities, and bonds payable. 6
11-3 Uncertain Aspects of Some Liabilities Three important questions that must be answered to know when a liability has been incurred... ➊ Who must be paid? ➋ When is payment due? ➌ How much is to be paid? 7 Estimated Liabilities When we are uncertain about the amount of the liability we can sometimes make a reasonable estimate of the amount. Such liabilities are known as estimated liabilities. Common estimated liabilities include: Warranty obligations Corporate income taxes 8 Warranty Liabilities The estimated liability that is created when a company sells products covered by a warranty. The seller reports the estimated warranty expense in the period in which the sale was made (Matching Principle). 9
11-4 Corporate Income Taxes Income tax expense for a corporation creates a liability that exists until the taxes are paid to the government. As interim financial statements are prepared, corporations estimate applicable taxes. Quarterly estimated tax payments are made to the government. 10 Deferred Income Tax Liability Because of differences between the tax law and GAAP, taxable income may be different from financial income. When this happens, income tax expense may be different from income taxes payable. The difference between the expense and payable is called a deferred income tax liability or asset. 11 Contingent Liabilities Contingent liabilities become definite liabilities only if some uncertain event actually takes place. Examples include potential legal claims or the guarantee of debt of another. 12
11-5 Contingent Liabilities You have to decide whether the event is Probable (likely), in which case you either record the liability if you figure out how much it will be; or disclose it if you can t. Possible, in which case you disclose it. Remote (unlikely), in which case you ignore it (don t disclose or record it). 13 Employee Benefits Insurance and Pensions Plans The amounts the company contributes to the employees insurance and pension plans are recorded as expenses. Vacation Pay Vacation pay is recorded as an expense as it is earned by employees. 14 Long-Term Liabilities Liabilities that are repaid after one year or a longer operating cycle. Can arise from... Borrowings from a bank. Issuing bonds to a number of creditors. Purchasing assets. Long-term leasing of assets. Present value concepts are often used. 15
11-6 What s money worth? I have a problem. As you know, my family sometimes comes over after class for dinner. My wife, old fashioned as she is, wants me to pay for dinner. Unfortunately, I forgot my wallet and have no money. So, the deal is this: How much will you give me today for my promise to give you back $20 in a month? 16 It s nice to have friends! Interest rate = 11.11% = $2 $18 Interest Principal Per month! That s an annual rate of 133.33% 17 What is that 133%? The rate of interest is composed of three parts: ➊ An amount just for giving up your money 2% to 4% ➋ An amount for inflation 2% now = The risk free rate 4% to 6% now ➌ Plus a premium for risk 127% = The rate of interest for me! 131% to 133% 18
11-7 For the next slides, you should use your financial calculator As you saw in the website, for most financial calculators I have a cheat sheet. My favorite is the iphone calculator, but if you have another that does PV and FV, that should be enough for this class. I suggested several in the syllabus. You will need one of those for finance. 19 Calculator setup Please do not get ahead of us, but do feel free to give or get help if needed. You need to set your calculator up right--see your calculator cheat sheet download: Be sure your calculator is in end mode (it should not have begin in the window). Except for 12c users, set your calculator for one period per year. To check this, enter 2 into n, 5 into I, 1000 into FV, 0 into payment, and calculate PV. Answer should be $907.03. 20 Check digits In the questions, I will give you check digits--the two digits surrounding the decimal point. For example, 321.72 will give you 1.7 as check digits. 21
11-8 Problem 1 Suppose you have $1000 that you want to invest at 8 percent interest for five years. How much will that money be worth at the end of the fifth year? The check digits are 9.3 22 This is a future value problem Year 0 1 2 3 4 5 6 Amount 1,000 8% How do we know? The problem asks what the amount is going to be worth in the future. 23 Answer 1 The answer is $1,469.30 As you can see, the check digits are the two digits surrounding the decimal point. If you have them right, you are pretty sure you have the answer right and don t have to say it out loud that gives everybody a chance to figure it out, not just the first person to get it. I ll give you check digits for many problems. 24
11-9 What s an annuity precisely defined? Equal payment equally spaced through time. There are two types: Ordinary annuity, where the first payment is a period from now. Annuity due, where the first payment is paid now. We will not see this kind of problem in this class. 25 How do I know what table to use? You have to ask yourself two questions: Is this an annuity? Do I want to know what the amount is going to be worth, or what it s worth today? 26 Problem 2 Let s turn our earlier example around. Someone promises you $1000 in five years. Using an interest rate of 6 percent, how much is that money worth today? The check digits are 7.2 27
11-10 This is a present value problem Year 0 1 2 3 4 5 6 Amount 1,000 747.26 6% How do we know? The problem asks what the money is worth today. 28 Problem 3 What if you are promised a series of even payments of $400 per year for five years. Let s suppose that the market rate of interest is 8 percent. How much is that series of payments worth today that is to say, how much would you take in cash today for it? Check digits: 7.0 29 This is a present value of an annuity problem. Year 0 1 2 3 4 5 6 Amount 400 400 400 400 400 1597.08 How do we know it s a present value problem? What s the money worth today is the question. How do we know it s an annuity? Look for the words per year with a repeated amount. 30
11-11 Problem 4 Suppose that you decide to deposit a constant amount of $100 per year into an account each year at the end of the year. How much will be in your savings account at the end of the third year if you earn 6 percent on the account annually? Check digits: 8.3 31 Future value of an annuity Year 0 1 2 3 4 5 6 Amount 100 100 100 318.36 Notice that you get no interest on the money deposited at year 3! This is a future value of an annuity problem because we have an annuity and we ask what it will be worth. 32 Problem 5 Suppose that I have a choice: Suppose that I am promised $5,000 in four years, or $4,000 today. If my interest rate is six percent, which should I take? 33
11-12 Problem 5 Oh my, what is the problem? It is a real life problem! It can be done in many ways: As a future value problem Year 0 1 2 3 4 5 6 Amount 4,000 As a present value problem Compare to $5000 Year 0 1 2 3 4 5 6 Amount 5,000 Compare to $4000 34 Compounding Periods Shorter Than a Year If the compounding period is less than one year, we make the following two adjustments... ➊ Divide the interest rate by the number of compounding periods per year. ➋ Multiply the number of years by the number of compounding periods per year. 35 Compounding Periods Shorter Than a Year Instead of $1,000 annual payments, let s assume that we will make a $500 payment semi-annually for each of the next three years with interest at 8%. 36
11-13 Compounding Periods Shorter Than a Year ➊ Interest rate adjustment 8% 2 = 4% interest rate per period ➋ Periods adjustment 3 * 2 = 6 periods This is a Present Value of an Annuity with n = 6, I = 4%, and PMT = 500. 37 Compounding Periods Shorter Than a Year PV = $2,621.07 If we made annual payments of $1,000, the present value is $2,577.10, which is lower than the semi-annual present value because we are making the semiannual payment sooner. 38 Applying Present Value Concepts to Long-Term Notes A long-term note payable covers more than one accounting period so the concept of compound interest is applicable. Let s begin by looking at a $100,000, 3- year note payable that has a 6% stated interest rate that is dated January 1, 20X1... 39
11-14 Note with a Single Payment Calculation of Compound Interest Amount of the note 100,000.00 Interest during 20X1 6,000.00 Ending balance 20X1 106,000.00 Interest during 20X2 6,360.00 Ending balance 20X2 112,360.00 Interest during 20X3 6,741.60 Ending balance 20X3 119,101.60 Interest = $6,000 + $6,360 + $6,741.60 = $19,101.60 40 Non-interest Bearing Note Example Assume we purchase a piece of equipment that has a retail price of $100,000 by issuing a five-year note payable for $100,000 (there is no stated interest rate of the note). How do we assign a value to the equipment we purchased? 41 Non-interest Bearing Note ➊ We could use the fair value of the equipment, or ➋ We could use the fair value of the note issued. In our example, let s assume that retail value is not an appropriate measure of fair value. 42
11-15 Non-interest Bearing Note We should record the asset purchased at the fair value of the note issued. To estimate fair value of the note we need to determine an appropriate interest rate. Let s assume the proper interest rate is 8%... 43 Non-interest Bearing Note Using the calculator, we enter 5 periods, 8% with an FV of $100,000. The present value of the $100,000 note payable is: $68,058.32 Let s make the journal entry to record the purchase 44 Non-interest Bearing Note Date GENERAL JOURNAL Page 3 Description Post. Ref. Debit Credit Equipment 68,058.32 Discount on Notes Payable 31,941.68 Long-Term Notes Payable 100,000.00 45
11-16 Non-interest Bearing Note At the end of the first year, we would make the following entry to accrue interest on the note: Date GENERAL JOURNAL Page 3 Description Post. Ref. Debit Credit Interest Expense 5444.67 Discount on Notes Payable 5444.67 Carrying value of the note $68,058.32 Proper interest rate 8% Interest expense $ 5,444.67 46 Non-interest Bearing Note After posting the entry to accrue interest the balance in the Discount on Notes Payable account is: GENERAL LEDGER Account: Discount on Notes Payable Number: 281 Balance Date Item Post. Ref. Debit Credit Debit Credit Jan. 1 Issue of note 31941.68 31941.68 Interest accrual 5444.67 26497.01 The new carrying value of the note is: Principal of note $100,000.00 Unamortized discount (26,497.01) Carrying value of note $ 73,502.99 47 Non-interest Bearing Note Interest expense for the second year would be calculated using the new carrying value of $73,502.99. Interest expense in the second year is: $73,502.99 *.08 = $5,880.24 At maturity, the discount is fully amortized and has a zero balance. So, the carrying value of the note will equal maturity value ($100,000). 48
11-17 Installment Notes Payable Require borrower to pay back the debt with a series of payments. Usually, each payment includes the accrued interest to date plus repayment of a portion of the principal. In this class, we will assume that the note payments are equal over time. That is the real world. 49 Installment Notes Payable Equal Payments Annual payments are constant. 14000 12000 10000 8000 6000 4000 2000 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Interest Principal The principal payments increase each year. Interest expense decreases each year. 50 Loan amortization problem Calculate the loan amortization schedule for a loan of $15,000, four year loan, with an interest rate of 10 percent. The annual payments are equal. First, what is the annual payment on that loan? Check digits: 2.0 51
11-18 Getting the payment In all problems, figure out what you know. In this problem, we have three knowns: We know the present value of the note, $15,000. We know its term, 4 years. We know its interest rate, 10 percent per annum. Please calculate the payment on the note. 52 Now set up your table Beg. Ending Year Prin. Payment Interest Principal Prin. {1} {2}=last {6} {3} {4}={2}*10% {5}={3}-{4} {6}={2}-{5} 1 15,000.00 4,732.01 2 3 4 53 The finished amortization Beg. Ending Year Prin. Payment Interest Principal Prin. {1} {2}=last {6} {3} {4}={2}*10% {5}={3}-{4} {6}={2}-{5} 1 15,000.00 4,732.06 1,500.00 3,232.06 11,767.94 2 11,767.94 4,732.06 1,176.79 3,555.27 8,212.67 3 8,212.67 4,732.06 821.27 3,910.79 4,301.88 4 4,301.88 4,732.06 430.19 4,301.87 0.01 54
11-19 Installment Notes Payable Equal Payments In your books, you will initially set up the note using its beginning balance as a credit, with the offsetting debit to whatever asset you got for the note. On an annual basis, you will make a credit entry to cash for the payment, and debit entries to interest expense and to the note, based on your schedule. 55 Assume you are the lender If you are the lender in the installment note, all of the same logic applies, but in reverse. You set up the note as an asset; you are receiving (debiting) cash on an annual basis; and you are reducing (crediting) the note and increasing your interest income annually. This is called a mirror transaction you are mirroring the debtor s entries. 56 Let s go back a couple weeks and see what you remember Suppose that you had an annuity of payments of $100 per year for each of the next ten years. Suppose that the market rate of interest were 7 percent. What would the value of that stream of payments be today? Check digits are 2.3 57
11-20 Another one! Suppose that you were promised a single payment of $1000 ten years from today, and again the market rate of interest is 7 percent. What would the value of that payment be today? Check digits are 8.3 58 Now a final one! Suppose that you had an annuity of payments of $100 per year for each of the next ten years plus a final payment of $1000 in year ten. Suppose that the market rate of interest were 7 percent. What would the value of the set of payments be today? Check digits 0.7 59 Of course, that s just the first two added up. What you ve just done is to value a bond. A bond is a stream of annual or semiannual interest payments followed by a final payment of principal. 60
11-21 The notation for bonds The bond you valued would be listed in the paper as ATT 10 s of 26 Issuer: The bond was issued by a small telecommunications company called ATT Coupon rate: The bond pays 10 percent of its par value annually in interest Maturity year: It will continue to do so until this date Not shown in the listing the current market interest rate for the bond! That comes from the market (or me in this class)! 61 Assumptions about bonds In this class, unless otherwise stated, we will make three assumptions about bonds: Bonds pay their interest annually. Bonds made their most recent interest payment just a moment ago. This allow the next one to be a year from now. The par value of a bond is $1,000. 62 Want to try some more? What s the value of an ATT 4 s of 21. Please raise your hand and give me your answer when you are done. Oh, you want an interest rate? Use 8 percent. 63
11-22 How did you get that? What s the value of an ATT 4 s of 21. Use an 8 percent market rate. The bond has a coupon rate of 4%. It lasts until 2021, 5 years from now. We have to present value the payments: PMT = 40; i=8%; FV = 1000; n=5; Calc PV 64 Still more Try this one: XYZ 10 s of 36. Use 10% Its value is $1,000. Whenever the coupon rate is equal to the market rate, the value of the bond is equal to par. If coupon is above market, the value is above par. If coupon is below market, the value is below par. 65 Try this one: USG 0 s of 56 Use 10% Still more This is a zero coupon bond, that makes all of its payment at the end of its life. Each year, the value grows because you are getting closer to the end of the life of the bond. Its value is $22.09 today 66
11-23 Advantages of Issuing Bonds No loss of control of the company. Interest is tax deductible. Increases return on equity. 67 Accounting for the Issuance of Bonds Prepare the journal entry to record the issuance of the bonds on 1/1/X1. GENERAL JOURNAL Page 42 Post. Date Description Ref. Debit Credit 100,000 Jan. 1 Cash Bonds Payable 100,000 Issued bonds for the company Long-term Liability 68 Bonds Sold at a Discount On December 31, 2015, Rose Company sold 1,000 of its bonds at a market interest rate of 12 percent. The bonds are listed as Rose 10 s of 20 ❶ Calculate the issue price of the bonds. ❷ Amortize the discount on the bonds. 69
11-24 Interest Method Amortization Table Bonds sold at a discount {1}=[Face * coupon] {2}= [Last {5} * Market rate] {3}={2} - {1} {4}=Face - {5} {5}=Last {5} + {3} Interest Interest Discount Unamortized Present Date Payment Expense Amortization Discount Value 1/1/16 72,095.52 927,904.48 12/31/16 100,000.00 111,348.54 11,348.54 60,746.98 939,253.02 12/31/17 70 Interest Method Amortization Table Bonds sold at a discount {1}=[Face * coupon] {2}= [Last {5} * Market rate] {3}={2} - {1} {4}=Face - {5} {5}=Last {5} + {3} Interest Interest Discount Unamortized Present Date Payment Expense Amortization Discount Value 1/1/16 72,095.52 927,904.48 12/31/16 100,000.00 111,348.54 11,348.54 60,746.98 939,253.02 12/31/17 100,000.00 112,710.36 12,710.36 48,036.62 951,963.38 12/31/18 100,000.00 114,235.61 14,235.61 33,801.01 966,198.99 12/31/19 100,000.00 115,943.88 15,943.88 17,857.14 982,142.86 12/31/20 100,000.00 117,857.14 17,857.14 (0.01) 1,000,000.01 The $0.01 in unamortized discount in year 12/31/20 is rounding error. 71 Bonds Sold at a Premium On December 31, 2015, Duck Company sold 1,000 of its bonds at a market interest rate of 8 percent. The bonds are listed as Duck 10 s of 20 ❶ Calculate the issue price of the bonds. ❷ Amortize the premium on the bonds. 72
11-25 Interest Method Amortization Table Bonds sold at a premium {1}=[Face * coupon] {2}= [Last {5} * Market rate] {3}={1} - {2} {4}={5}-Face {5}=Last {5} - {3} Interest Interest Premium Unamortized Present Date Payment Expense Amortization Premium Value 1/1/16 79,854.20 1,079,854.20 12/31/16 100,000.00 86,388.34 13,611.66 66,242.54 1,066,242.54 12/31/17 73 Interest Method Amortization Table Bonds sold at a premium {1}=[Face * coupon] {2}= [Last {5} * Market rate] {3}={1} - {2} {4}={5}-Face {5}=Last {5} - {3} Interest Interest Premium Unamortized Carrying Date Payment Expense Amortization Premium Value 1/1/16 79,854.20 1,079,854.20 12/31/16 100,000.00 86,388.34 13,611.66 66,242.54 1,066,242.54 12/31/17 100,000.00 85,299.40 14,700.60 51,541.94 1,051,541.94 12/31/18 100,000.00 84,123.36 15,876.64 35,665.29 1,035,665.29 12/31/19 100,000.00 82,853.22 17,146.78 18,518.52 1,018,518.52 12/31/20 100,000.00 81,481.48 18,518.52 (0.00) 1,000,000.00 74 Types of bonds Bonds may be backed by A mortgage on specific property (mortgage bond) A lien interest in equipment (equipment trust) Or nothing at all (debenture) To find out what backs a bond, and to find out about any other features it has, read an agreement called the indenture. 75
11-26 End of evening 8 Thank you. I look forward to seeing you next week. Next week we will continue our discussion of present value applied in different ways. Have a great week! 76